Investing in real estate or a retirement account are two common – and smart – money strategies that can become even more advantageous when combined. By using the right type of IRA, you can invest in property as part of your retirement plan, allowing you to combine the investment benefits of real estate with the tax benefits of an IRA.
But there are IRS rules to be aware of when using this strategy and, if you run afoul of these, the penalties can be costly. Here are a few important steps and guidelines to keep in mind if you are investing in real estate using an IRA.
Setting Up a Self-Directed IRA
In order to buy real estate for your IRA, you need to set up a self-directed IRA with an investment company that allows such purchases. Self-directed IRAs are managed by custodians and offer a wider range of investment options compared to large brokerage firms, which typically disallow real estate investment. These large firms limit your investment options in order to keep their own expenses down.
Once you find the right company, setting up a self-directed IRA is a simple process. If you already have your money in a regular IRA, you can rollover those funds to a new self-directed IRA.
Buying the Right Property, From the Right Seller
While there are no rules on the type of real estate you can buy with an IRA, there are some strict rules about who you can buy the properties from. You are not allowed to transfer real estate that you currently own into your IRA. You also are not allowed to buy property from a list of “disqualified persons” determined by the IRS. This list includes family members and anyone else with whom you have an existing, personal relationship.
The IRS created this rule to prevent people from buying real estate at an artificially low price and taking unfair advantage of tax benefits when they later sell the property at market prices. The penalties for violating this rule can be steep – the IRS will force you to withdraw real estate out of your IRA portfolio, which would incur taxes and, possibly, a 10% penalty on the value of that withdrawal.
It’s also important to note that you need to put the property title in the name of your IRA, not your own name. Officially, your IRA owns the property, not you. Consult with your IRA custodian on the title when you make the purchase so that you can avoid problems down the road.
Financing Your Purchase
An all-cash purchase – meaning, in lieu of a mortgage, you pay off the entire property all at once – is probably the best way to buy real estate through your IRA. This approach can help you save on taxes and extra financing costs.
If that is not an option for you, it’s still possible to qualify for financing for an IRA investment purchase. But it is more difficult than securing financing for a regular, non-IRA real estate purchase because the lender can only use the actual piece of investment real estate as collateral. You are not allowed to back up an IRA real estate purchase loan with your personal assets. As a result, you’ll likely need to make a larger down payment and owe a higher interest rate on the loan.
Borrowing money can also lead to extra taxes on any rental income you will accrue through this property. The IRS charges Unrelated Business Income Tax (UBIT) when you borrow money to buy an income-producing property for your IRA. This tax applies to the share of the income equal to the amount you borrowed. For example, if you borrowed 50% of the price of the property, you would owe UBIT on up to 50% of your rental income.
Managing Your Investment
After you have made the purchase, you need to make sure you do not run afoul of IRS regulations when you manage the property. The IRS has very strict rules around IRA investment property management. You must pay for any expense that is related to your investment real estate using IRA funds. This includes any repairs, renovations, utility bills, property taxes, and more, so make sure you keep some extra cash in your IRA account to cover these expenses.
In addition, according to IRS rules, you are not allowed to even make repairs yourself to the property. You must hire someone for all repair and maintenance jobs using IRA funds. If you are caught breaking this rule, the IRS can force you to take a distribution.
You are also barred from living in or using your IRA investment real estate for your own personal use. For example, if you buy a beachfront property, you cannot vacation there. Once again, making this mistake can lead to a forced distribution.
Investing in real estate through your IRA takes some extra work but the tax benefits can also make this effort worthwhile.